Friday, March 28, 2014

SEC ENFORCEMENT ACTIONSSEC Obtains Order Enforcing Compliance with Order to Pay Over $5 Million in Disgorgement, Prejudgment Interest, and Civil Penalties, March 26, 2014, (Litigation Release No. 22952)

An opinion and order were entered this week "directing Walter Gerasimowicz, Meditron Asset Management, LLC, and Meditron Management Group, LLC to comply with the SEC order requiring them to pay $3,143,029.41 in disgorgement and prejudgment interest, and a civil penalty of $1,950,000." The SEC had previously found that the Respondents had "willfully violated the antifraud provisions" of the securities laws.

A summary judgment was entered against Jonathan Curshen which permanently enjoins him from future violations of the securities laws, imposes a penny stock bar against him, orders him to pay a $65,000 civil penalty, and holds him "jointly and severally liable with Defendant Bruce Grossman for $76,000 in disgorgement, plus $18,599.86 in prejudgment interest." In 2012, a final judgment was entered against Grossman that permanently enjoins him from future violations of the securities laws and imposes a penny stock bar against him. Grossman's liability "was deemed fully satisfied by Grossman's criminal forfeiture order in United States v. Grossman."

The SEC's original complaint found that the defendants "engaged in a fraudulent broker bribery scheme designed to manipulate the market for the common stock of Industrial Biotechnology Corp."

District Court Enters Final Judgments of Permanent Injunction Against All Defendants and Orders Penny Stock and Officer and Director Bars Against Linda Grable and Allan Schwartz, March 25, 2014, (Litigation Release No. 22950)

Final judgments were entered against Imaging Diagnostic Systems, Inc., Linda Grable, its CEO, and Allan Schwartz, its CFO, that permanently enjoin them from future violations of the securities laws, and impose penny stock bars and officer and director bars against Grable and Schwartz as well as order Grable and Schwartz to each pay $150,000 civil penalties.

The SEC's original complaint found that the defendants "made material misstatements and omissions in Imaging Diagnostic's public filings about the timing of the company's Food and Drug Administration application and its failure to remit payroll taxes to the Internal Revenue Service."

An emergency Order (PDF) has been issued that freezes and preserves "the remaining pool participant assets under the control of Michael James Seward, Yan Kaziyev, and their company SK Madison Commodities, LLC" and "freezes assets controlled by a successor company, SK Madison, LLC, prohibits Seward, Kaziyev, and SKMC from destroying books and records, and allows the CFTC immediate access to those records." The CTFC's original complaint (PDF) alleges that the defendants "fraudulently solicited more than $1.3 million from members of the public to trade futures in a commodity pool by...misrepresenting their trading practices and historical trading returns,...prepared and distributed...false account statements and performance reports showing huge profits" and "divert[ed] large amounts of pool participants’ funds for [their] own use." The CFTC seeks full restitution, disgorgement, civil penalties, permanent registration and trading bans, and a permanent injunction against the defendants.

Federal Court in North Carolina Orders Mitchell Brian Huffman to Pay $2.1 Million Penalty for Defrauding Customers of More than $3.2 Million in Commodity Pool Scheme, March 24, 2014, (CFTC Press Release No. 6891-14)

The CFTC obtained a federal court supplemental Consent Order (PDF) which requires Mitchell Brian Huffman "to pay a $2.1 million civil monetary penalty for operating a fraudulent commodity pool scheme that defrauded customers of more than $3.2 million in connection with exchange-traded commodity futures contracts." A separate Order requires Huffman "to pay $3.2 million in restitution to defrauded customers" as a part of his criminal sentencing in United States v. Mitchell Brian Huffman. A Consent Order (PDF) was entered in 2012 that "imposes permanent trading and registration bans against Huffman, prohibits him from violating federal commodities law, as charged" as well as orders him to pay the civil penalty "as provided for in the supplemental Order."

Morgan Stanley has agreed to pay "a $200,000 civil monetary penalty to settle CFTC charges that it exceeded speculative position limits in soybean meal futures contracts trading on the Chicago Board of Trade ." The CTFC Order (PDF) against MSGCI also requires "MSGCI to cease and desist from further violations" of the federal commodities laws.

A judgment was entered against Patrick Cole and his company, Global Strategic Marketing, Inc., for allegedly committing "fraud in connection with a multi-million dollar off-exchange foreign currency Ponzi scheme." The court's Order (PDF) "imposes disgorgement of $1,146,399,...requires Cole and GSM to pay civil monetary penalties of $1,146,39,...imposes permanent trading and registration bans on Cole and GSM, and prohibits them from violating the anti-fraud provisions of the Commodity Exchange Act, as charged."

In May 2013, a judgment was entered "requiring Defendants CDL, its principals and controlling persons Kevin Harris, Keelan Harris, and Karen Starr, and Defendant Investment International Inc., to pay over $23 million in civil monetary penalties and restitution in connection with this fraudulent forex Ponzi scheme."

Wednesday, March 26, 2014

We have noted in our research and our posts that non-traded investments including non-traded real estate investment trusts (REITs), business development companies (BDCs), oil & gas and equipment leasing partnerships typically have extremely high upfront and ongoing fees. Because of these high costs, illiquidity, lack of transparency and conflicts of interest, these investments should underperform liquid, lower-cost traded investments with similar underlying exposures. For example, non-traded REITs should underperform liquid, low-cost traded REITs. Essentially, since non-traded REITs are in the same market for real estate that mutual funds, exchange-traded funds, and other real estate investments invest in, non-traded REITs can’t on average make up in returns what they take out in fees.

BlueVault Partners, LLC is an investment research firm focused on non-traded REITs and business development companies (BDCs). In September 2012, BlueVault and the University of Texas at Austin's Real Estate Finance and Investment Center issued a report that looks at the returns on a sample of 17 non-traded REITs. They then updated their study in November 2013 to cover 10 more non-traded REITs. While the 2013 study is not publicly available, a summary of their findings is available here.

On the surface, both the 2012 and 2013 versions of their study support our interpretation. The 2012 study notes:

Adding back a plausible estimate of fees leads to estimates of unloaded return that suggest that nontraded REITs perform fairly similarly to their [traded REIT] benchmarks in terms of their real estate portfolios’ returns.

Likewise, from the 2013 study's summary:

Removing the effects of a hypothetical 12% front-end load for all nontraded REITs in the sample, the average nontraded REIT achieved comparable returns to the FTSE NAREIT publicly traded benchmark returns.

Adding back in the 12% upfront fees, investors in the non-traded REITs covered by the Blue Vault study did about as well as traded REITs. More clearly, investors in the BlueVault REITs had holding period returns which were 12% lower than holding period returns in traded REITs.

However, the truth about non-traded REITs is likely even worse because the BlueVault study only considers the few REITs that had "provided shareholders with full liquidity" through a merger, liquidation, or public listing. These are likely to have been the best performing non-traded REITs; excluded were many of the non-traded REITs that have suffered huge dollar value losses -- for examples, InlandAmerican, Behringer Harvard REIT I (a/k/a TIER REIT), and CNL Lifestyle Properties (a/k/a CNL Income Properties) were not included. Including only the 'full-cycle' non-traded REITs creates a conspicuous selection bias that overstates the returns to non-traded REITs as a whole.

The BlueVault study is analogous to comparing the returns to venture capital investment in social media companies to returns in the stock market but only considering the experience of venture capital investors in Facebook, Twitter and LinkedIn. Even with this selection bias, the Blue Vault study had to add 12% to the returns earned by investors in the non-traded REITs it covered to get them to equal the returns earned by investors in traded REITs over the same time periods.

By choosing only so-called 'full cycle' non-traded REITs, the BlueVault study presents a biased look at the market for non-traded REITs. By our estimates, BlueVault's sample reflects only about half of the capital raised by the over 100 non-traded REITs in the United States, and does not fully reflect what many non-traded REIT investors have experienced.

In upcoming posts, we will report on our analysis of returns earned by investors in almost all non-traded REITs, not just the winners included in the industry’s study.

What did the MSRB do? It destroyed the evidence and tried to re-write history.

The Puerto Rico offering document (available here) says the bonds can only be traded in denominations greater than $100,000. The Bond Buyer story pointed out that 70 customer trades in the first few days of trading (by 4:57 pm on March 18, 2014) were below this minimum denomination intended to protect investors. The trading in this Puerto Rican bond can be found here but you won’t find evidence of these trades any more in the trades reported on the MSRB website. What happened? Shockingly, the MSRB and the brokers who executed these violative and potentially fraudulent trades edited the tape to delete or modify these trades even though they had already settled.

Compare for instance, this screen shot of EMMA taken on March 19, 2014 between 2:55 and 3:17 pm which shows 5 sales to customers in violation of the offering documents and MSRB rules

with this screenshot from EMMA for the same time period taken at 11:45 am on March 25, 2014. Notice the 5 “Customer Bought” for quantities less than $100,000 have disappeared.

What happened? The MSRB and the brokerage firms that inappropriately executed trades got together and edited the tape. For instance, the $50,000 trade at $95.387 was deleted a day after the trade settled when Kyle Glazier and Lynn Hume’s story appeared. See the Bloomberg screenshot below.

The $25,000 trade at $98.5 was re-written to be a $100,000 trade - two days after the trade settled. See the Bloomberg screenshot below.
These Bloomberg screenshots allow us to find the MSRB’s missing 18 minutes of tape. Without Bloomberg capturing trades and modifications of trades we would never know what the MSRB and broker dealers have done to sanitize history.

So how thorough was the MSRB’s scrubbing of history? Of the 70 sales to customers in violation of investor protection rules by the end of the March 18, 2014, only 8 remain. If you want to see them, look quickly because the MSRB and the industry continues to rewrite this history each day and the evidence of bad trades is shrinking each day.

This bond isn’t the only bond that was traded in denominations which were not allowed by the offering documents and MSRB rules. We’ve identified a number of bond issues in which many small trades were executed in violation of offering circulars and MSRB rules. For instance, the 2012 Michigan Finance Authority (Concord Academy) bonds appear to have an unambiguous $100,000 minimum authorized denomination. The offering document is available here. The trading activity for this bond is available (at least until the MSRB changes it) here and includes trades less than $100,000. Also, the Harbor Point bonds underwritten by Stone & Youngberg (offering document here and trading here) appear to have had many trades well below the $100,000 minimum denomination.

Why does it matter?

The MSRB is supposed to protect investors. The MSRB’s re-writing of inconvenient settled trade history highlights how the MSRB is more concerned about bond dealers than it is concerned about issuers and investors. MSRB continues to condone more subtle forms of investor abuse such as excessive markups (which we have written about in blog posts here and in our research paper here) and protect dealers from the sunshine.

While FINRA investigates the trades the MSRB has tried to edit out of history, the Securities and Exchange Commission needs to force the MSRB to take its investor protection mandate seriously.

There’s more; we will discuss other problems with the trading in the Puerto Rico bond in future blog posts.

UPDATE (4:40pm): Kyle Glazier and Lynn Hume have a followup story at The Bond Buyer discussing these cancellations.

Friday, March 21, 2014

Frank Mazzola, brokerage firm Felix Investments, LLC, and investment adviser Facie Libre Management, Associates, LLC, have been charged with defrauding "investors in funds created to purchase shares of Facebook, Twitter, and other technology companies prior to their initial public offerings." According to the SEC, Mazzola and Felix Investments "arranged to be paid secret commissions in connection with their funds’ acquisition of Facebook stock and on the sales of fund interests to new investors." They, along with "Facie Libre Management Associates, LLC, sold interests in the pre-IPO funds despite knowing the funds did not own all of the Facebook shares that they told investors." Furthermore, "Mazzola and Felix Investments misrepresented the financial condition of Twitter, then a privately-held company, and misled investors about their attempt to acquire shares of Zynga Inc. stock."

The defendants have consented to the entry of a judgment that orders them to pay $500,000 total in disgorgement, prejudgment interest, and a civil penalty, and permanently enjoins them from future violations of the securities laws. Mazzola has also been barred from the securities industry, with right to reapply in three years.

Steven Metro, a managing clerk at Simpson Thacher & Bartlett, and Vladimir Eydelman, a registered representative who was at "Oppenheimer and is now at Morgan Stanley," have been charged with "insider trading around more than a dozen mergers or other corporate transactions for illicit profits of $5.6 million during a four-year period." Metro would learn of the mergers and then tip a middleman, who in turn tipped Eydelman. "Eydelman went on to use the illicit tip[s] to illegally trade on his own behalf as well as for family members, the middleman, and other customers."

The SEC has charged the defendants with violating various sections of the securities laws and seeks disgorgement, prejudgment interest, penalties, and permanent injunctions from future violations.

Criminal charges have been announced against the defendants in a parallel action.

A jury found Robert A. DiGiorgio, "owner and President/CEO of Radius Capital Corporation, liable for securities fraud in connection with the issuance of mortgage-backed securities guaranteed by the Government National Mortgage Association." According to the SEC, under DiGiorgio's direction Radius sold "at least fifteen mortgage-backed securities with a total principal amount of over $23 million" and induced "Ginnie Mae to guarantee these securities" by stating "to Ginnie Mae and investors that all loans backing the securities were or would be insured by the Federal Housing Administration." In reality, allegedly approximately 70% of the loans were not FHA insured. Furthermore, DiGiorgio allegedly "directed Radius employees to ignore underwriting guidelines and knowingly approved low-quality, improperly documented, and fraudulent loans." The SEC seeks enjoinment from future violations of the securities laws, disgorgement, and civil penalties.

According to the complaint (PDF), David J. Cancian used insider information to trade ahead of an announcement that caused American Superconductor Corporation's "stock price to tumble 42%. Cancian made profits and avoided losses of over $46,000." Cancian has agreed to a judgment that enjoins him from future violations of the securities laws and orders him to pay over $97,000 in disgorgement, prejudgment interest, and a civil penalty.

According to the complaint (PDF), Anshoo R. Sethi, A Chicago Convention Center, LLC, and Intercontinental Regional Center Trust of Chicago, LLC raised "approximately $158 million dollars from...investors as part of a fraudulent offering that targeted foreign nationals who sought to invest in the U.S. economy and gain a legal pathway to citizenship through the EB-5 Immigrant Investor Program." The defendants have agreed to a final judgment that permanently enjoins them from future violations of the securities laws, orders "joint-and-several liability for over $11.5 million in disgorgement and prejudgment interest," enjoins and restrains the defendants from offering or selling securities "issued by any of the defendants or issued by any entity owned or controlled by Sethi" for twenty years, orders Sethi to pay a $1 million civil penalty, and orders ACCC and IRCTC to "wind up and dissolve after satisfying their payment obligations."

Last week, the SEC filed an emergency action against John Babikian a promoter behind "AwesomePennyStocks.com and its related site PennyStocksUniverse.com." According to the SEC, Babikian has been committing "a brand of securities fraud known as 'scalping.'" In February 2012, the APS websites "disseminated e-mails to approximately 700,000 people...recommend[ing] the penny stock America West Resources Inc." The emails failed to disclose that Babikian held over 1.4 million shares in America West stock, "which he had already positioned and intended to sell immediately through a Swiss bank." Without the "fraudulent touts, Babikian could not have sold more than a few thousand shares at an extremely lower share price." Babikian was allegedly "attempting to liquidate his U.S. assets, which he holds in the names of alter ego front companies." The SEC's emergency order "freezes Babikian's assets, temporarily restrains him from further similar misconduct, requires an accounting, prohibits document alteration or destruction, and expedites discovery."

According to the complaint (PDF), Steven Lyn Scott "fraudulently solicited at least $1,146,000 from at least 43 pool participants...to participate in pooled investment vehicles in the name of an entity he owned and controlled, Stewardship Financial Exchange, Inc." Instead of trading the funds, Scott allegedly "misappropriated 50 percent of pool participants’ funds by depositing their funds into his personal and corporate bank accounts, and then...subsequently misappropriated the remaining funds throughout the relevant period by trading them in his personal trading accounts." Additionally, Scott allegedly omitted material facts.

The CFTC seeks "civil monetary penalties, restitution, disgorgement of ill-gotten gains, trading and registration bans, and a permanent injunction against further violations of the federal commodities laws."

Gold Distributors Inc. and its sole owner, Jordan Cain, have been charged by the CFTC with " engaging in illegal, off-exchange financed transactions in precious metals with retail customers." According to the complaint (PDF), "between January 2012 and February 2013, GDI and Cain solicited retail customers...to buy physical precious metals, such as gold and silver, in off-exchange leverage transactions." The customers paid "GDI a portion of the purchase price for the metals, and another entity, AmeriFirst Management, LLC, financed the remainder of the purchase price, while charging the customers interest on the amount they purportedly loaned to customers." Allegedly, "GDI’s customers never took delivery of the precious metals they purportedly purchased." The CFTC seeks disgorgement, "restitution for the benefit of defrauded customers, civil monetary penalties, permanent registration and trading bans, and a permanent injunction from future violations of federal commodities laws."

According to the complaint (PDF), Bradley A. Miklovich, a former senior commodities analyst with Rice Investment Company, "engaged in unauthorized trading for two customers’ accounts, made material misrepresentations and omissions in connection with his unauthorized trading, and falsified Rice’s internal trading documents and a customer’s account statements to conceal his unauthorized trading." The two accounts "sustained losses totaling approximately $574,323" due to Miklovich's unauthorized trading. The CFTC seeks "restitution for monies Rice paid to its clearing FCM to compensate customers for their trading losses, civil monetary penalties, permanent registration and trading bans, and a permanent injunction prohibiting Miklovich from violating federal commodity laws."

According to the complaint (PDF), Robert S. Leben and Amy L. Leben "fraudulently solicit[ed] and/or accept[ed] at least $3.2 million from pool participants in connection with their operation of the [Structured Finance Group Corporation] commodity pool from August 2008 to the present." The Lebens have been charged with "misappropriating pool participant funds and failing to register with the CFTC as Commodity Pool Operators in connection with their operation of SFG." Additionally, Amy Leben has been charged "with improper operation of the pool." Furthermore, the Lebens allegedly "operated SFG as a Ponzi scheme" to perpetuate their fraud. The CFTC "seeks a permanent injunction from future violations of federal commodities laws, permanent registration and trading bans, full restitution to defrauded pool participants, disgorgement of any ill-gotten gains, and civil monetary penalties."

The CFTC issued an order (PDF) that files and settles charges against Sean R. Stropp for allegedly "making false and misleading statements of material fact, and omitting material facts, to CFTC staff during a CFTC Division of Enforcement investigation." The order requires him to pay a $250,000 civil penaltY, requires him to "cease and desist from violating the relevant provision of the CEA and permanently prohibits him from, directly or indirectly, engaging in trading on or subject to the rules of any registered entity."

The SEC has filed a subpoena enforcement action against Charles Riel III a/k/a Chuck Riel and REinvest LLC. The SEC previously served Riel and REinvest "with document subpoenas in January 2014" and a subpoena for Riel to "appear for sworn testimony in February 2014." According to the SEC, Riel and REinvest failed to produce any documents and Riel failed to appear for testimony. The SEC is investigating "whether Riel, REinvest, and others are violating anti-fraud or other provisions of the federal securities laws in connection with an investment marketed by REinvest."

According to the complaint (PDF), Ronald N. Dennis, a former analyst at an affiliate of hedge fund advisory firm S.A.C. Capital Advisors, received insider tips from Jesse Tortora, who was then an analyst at Diamondback Capital, and Matthew Teeple, an analyst at a San Francisco-based hedge fund advisory firm, regarding impending announcements at Dell Inc. and Foundry Networks. Dennis then allegedly used this information to enable hedge funds to illegally trade and gain over $700,000 in illicit profits combined.

Dennis has agreed to a final judgment that permanently enjoins him from future violations of the securities laws, orders him to pay over $200,000 in disgorgement, prejudgment interest, and penalties, and bars him from the securities industry.

According to the complaint (PDF), Alexander H.G. Mascioli and "his alter-ego, purported hedge fund, North Street Capital, LP, ... made a fraudulent May 2012 offer to acquire all outstanding shares of Winnebago Industries, Inc.'s common stock." This alleged fraudulent offer caused WGO's stock price and trading volume to increase significantly.

The defendants have consented to a final judgment that permanently enjoins them from future violations of the securities laws, orders them to pay, jointly and severally, a $100,000 penalty, and imposes a permanent officer-and-director bar against Mascioli.

According to the complaint (PDF), Belmont Partners, LLC, "a Virginia-based 'shell packaging' company and its CEO," Joseph Meuse, facilitated "a penny stock scheme." The defendants have agreed to be permanently enjoined from violating the Exchange Act and Securities Act and have agreed to pay $224,500. Additionally, Meuse has agreed to a penny stock bar and a 5 year-minimum officer-and-director bar. Thomas Russo, who was named as a relief defendant, has agreed to pay $70,075.

Last week, Craig A. Karlis, the former owner of Boston Trading and Research, LLC, "pled guilty to charges stemming from his role in an investment scheme that defrauded more than 1,000 investors out of more than $30 million." His sentencing is scheduled for June 2, 2014. Ahmet Devrim Akyil, his business partner, was charged with 10 counts of wire fraud. According to the US Attorney's Office, Akyil left the US for Turkey in 2009.

In October 2010, the SEC filed "a civil injunctive action...against BTR, and its principals Ahmet Devrim Akyil and Craig Karlis for fraudulently raising millions of dollars from investors in a purported foreign currency (Forex) trading venture." The SEC's pending complaint alleges that the defendants violated the Securities Act and the Exchange Act and it seeks "the entry of a permanent injunction, disgorgement of ill-gotten gains plus prejudgment interest, and the imposition of civil monetary penalties."

Final judgments were entered against seven defendants "in the pending enforcement action arising from the 'pay-to-play' scheme involving the New York State's Common Retirement Fund." Beginning in 2009, the SEC filed "securities fraud and related charges against several participants in the scheme, including Henry Morris, the top political advisor to former New York State Comptroller Alan Hevesi, and David Loglisci, formerly the Deputy Comptroller and the Common Fund's Chief Investment Officer." According to the SEC, "Morris and Loglisci orchestrated a scheme to extract sham finder fees and other payments and benefits from investment management firms seeking to do business with the Common Fund." In total, the SEC charged seventeen defendants. The civil action "had been stayed pending the outcome of the New York Attorney General's Office's parallel criminal action against some of the defendants charged by the Commission." The SEC issued administrative orders in addition to the judgments entered in the court action that impose "remedial sanctions against Morris, Loglisici, and Julio Ramirez (a former broker who facilitated certain of the payments made to Morris)."

Morris, "who previously pled guilty to parallel criminal charges and was sentenced to a multi-year prison term and ordered to forfeit $19 million in fees, consented to entry of a judgment" that permanently enjoins him from future violations of the securities laws, bars him from the securities industry, bars him from participating in penny stock offerings, and bars him from appearing or practicing before the SEC as an attorney.

Loglisci, "who also pled guilty to parallel criminal charges and was sentenced to a term of conditional discharge due to his cooperation with law enforcement authorities, consented to entry of a judgment" that permanently enjoins him from future violations of the securities laws and bars him from appearing or practicing before the SEC as an attorney.

Ramirez, "who also pled guilty to parallel criminal charges and was sentenced to a term of conditional discharge due to his cooperation with law enforcement authorities and ordered to forfeit $289,875 in fees," consented to a final judgment that permanently enjoins him from violating various provisions the securities laws, bars him from the securities industry, and bars him from participating in a penny stock offering, "subject to a right to reapply after three years."

Nosemote LLC and Pantigo Emerging LLC, "two shell companies through which payments to Morris were funneled," have consented to a final judgment that permanently enjoins them from future violations of the securities laws.

Tuscany Enterprises LLC and W Investment Strategies LLC, "two entities previously associated with defendant Barrett Wissman, against whom a consent judgment was previously entered imposing permanent injunctive relief," consented to a final judgment that permanently enjoins them from future violations of the securities laws and orders them to pay over $3.4 million in disgorgement and prejudgment interest.

Last week, a jury found that Andrew W. Jacobs, and his brother Leslie J. Jacobs II, were guilty of insider trading "in connection with the December 2009 tender offer for Chattem Inc." The jury found that the defendants violated the Exchange Act. "In its complaint, the SEC sought permanent injunctions, disgorgement with prejudgment interest, and civil monetary penalties" against the brothers, as well as "an officer and director bar against A. Jacobs."

Last summer SLCG distributed an analysis of the markups and markdowns on over 20 million municipal bond trades. We estimated that investors have been charged $1 billion a year in excessive markups on municipal bond trades since 2005. Our study, Using Emma to Assess Municipal Bond Markups is available here. The SLCG report received significant coverage including The Bond Buyer article, Study Claims Billions of Dollars of Excessive Muni Markups.

Investors pay high markups on municipal bond trades because of a lack of pre-trade price transparency and post-trade markup disclosure. Simple disclosure requirements already in place in the corporate bond market would dramatically improve how the municipal bond markets operate for investors and taxpayers. The merits of such reform are now clear after a dozen published research papers on excessive markups in the municipal bond markets.

Current SEC Commissioner Mike Piwowar contributed an influential paper to this literature, “Secondary Trading Costs in the Municipal Bond Market” (download here), and has been outspoken about the need to provide investors better disclosure (see Bond Buyer profile of Dr. Piwowar here).

Those of you interested in getting up to speed quickly on the markup issue might click on our prior blog posts on the topic:

Friday, March 7, 2014

A summary judgment was entered against StratoComm Corporation, its CEO, Roger D. Shearer, and its former Director of Investor Relations, Craig Danzig, for issuing and distributing "public statements falsely portraying the penny stock company as actively engaged in the manufacture and sale of telecommunications systems for use in underdeveloped countries." According to the SEC, the defendants "sold investors more than $4 million worth of StratoComm stock in unregistered transactions." The SEC has charged the defendants with violating various provisions of the securities laws. "The court has not yet determined the appropriate relief against StratoComm, Shearer, and Danzig."

Last week, a federal grand jury returned "an 11-count indictment against Gregory Webb, the CEO and President of InfrAegis, Inc." Webb and InfrAegis allegedly obtained funds from investors through the offer and sale of InfrAegis stock "by making false representations about the solvency and financial condition of InfrAegis, about contracts that the company allegedly expected to be awarded or had been awarded, and about the expected and actual return on investment investors would get from the company." The SEC filed a civil enforcement action in 2011 "against Webb and InfrAegis based, in part, on the conduct alleged in the criminal indictment." The SEC had charged the defendants with violating the Securities Act and Exchange Act. Webb faces "eight counts of mail fraud and three counts of wire fraud, each of which carries a maximum penalty of 20 years in prison and a $250,000 fine. Restitution is mandatory."

The spectacular collapse of the Willow Fund was not the result of general market conditions operating on the Fund’s disclosed investment strategy. The losses occurred because, rather than investing in distressed debt as it said it would, the Fund’s managers placed a 20-1 bet that credit spreads would widen further and UBS’s investors lost.

Investors lost between $278.4 million and $419.2 million as a result of the Willow Fund’s undisclosed change in investment strategy

Investors in the Willow Fund as a whole lost $25.9 million from inception to December 31, 2012. The same investor capital deposits and withdrawals in a diversified portfolio of high yield bonds would have had a $190.4 million gain over the same time period and so Willow Fund investors as a whole lost $216.3 million over the active life of the Fund.

The Willow Fund was really two very different funds. From inception to June 2007, the Fund invested in distressed obligations and hedged some of its credit risk exposure by purchasing CDS contracts. During this period, investors had a gain of $252.5 million. This gain was $134.3 million more than the $118.2 million the same investor capital flows would have earned in a diversified, non-leveraged portfolio of junk bonds.

After July 1, 2007, the Willow Fund was completely different than its previous self and completely different than what its SEC disclosures described. The Fund was a high-cost, massive short bet on credit risk. The Fund lost $278.4 million from July 1, 2007 to December 31, 2012. Approximately half of these losses were from CDS premiums the Fund paid but stopped reporting separately in its SEC filings after June 30, 2007.

If the Willow Fund investors’ capital values on June 30, 2007 had been invested in a diversified portfolio of junk bonds, they would have earned $140.9 million up through December 31, 2012. Willow Fund investors thus lost $419.2 million compared to the high yield bond market after the Fund changed its strategy (and its accounting treatment of CDS premiums).

If instead of investing the members’ capital accounts on June 30, 2007 in a diversified portfolio of junk bonds we just allow the alternative portfolio of junk bonds to continue from June 30, 2007 until December 31, 2012 the estimated market adjusted damages during the second period would be $350.6 million rather than $419.2 million.

UBS Made over $100 million selling and managing the Willow Fund

UBS made over $100 million managing and selling the Willow Fund. UBSFA received a management fee of 1.25% of the net assets of the fund annually which added up to $41.2 million. UBS also received an incentive fee equal to 20% of the Fund’s profits above a high watermark. The incentive fees totaling $54.3 million were added to UBSFA’s Managing Member capital but were virtually completely withdrawn prior to the Fund’s losses and so were not at risk with the Fund’s investor’s capital. See Table 2. UBS also received up to a 2% placement fee for acting as the Placement Agent for the Fund.

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